The Power of "Q"

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The Daily Reckoning | Monday, December 12, 2011 Cutting through the static...submerging markets lead the way, What one oft-overlooked indicator says about the housing market, Plus, Bill Bonner on behavioral changes to watch out for and how the Pentagon is doing Osama bin Laden’s dirty work for him... ------------------------------------------------------- 4 Times More Oil Than The Bakken? North Dakota’s booming Bakken oil reserve has created plenty of overnight millionaires. But now a revolutionary new technique — created right here in the US — could produce up to 4 times as much oil as the Bakken... And potentially mint an even bigger wave of millionaires in the process... So what exactly is it? Just Click Here Now For The Full Story.   Straining to Hear News Beyond the Static US Markets Remain Stagnant Despite Bursts of Volatility   Eric Fry Reporting from Laguna Beach, California... The financial markets are serving up more static than an AM radio station along some forlorn stretch of Route 66. Every once in a while, you think you can discern something recognizable...you think you can make out something that sounds vaguely familiar. A moment later, it’s all static again. For several months, the major trend in the financial markets has been no trend at all. Just static. During the last four months, for example, the Dow Jones Industrial Average has delivered an astonishingly large number of 100-point days. But on a net basis, the Dow hasn’t budged over that timeframe. Since July 27th, the Dow has traded up or down more than 100 points on two out of every three trading days. Furthermore, many of those 100-point days were actually 200-, 300- or 400-point trading days! (As recently as June and July, hundred-point days were relatively rare — only about one day in three). Despite all those gut-wrenching 100-point days, however, the Dow is still hanging around the 12,000 level — right where it was at the end of July. Clearly, volatility is a bull market, even if stocks are not. The euro zone probably deserves most of the blame for this fruitless, directionless volatility. One moment, the euro seems destined to blow apart. The next moment, the European leadership announces some sort of crowd-pleasing rescue effort...and then a few moments after that, the crowd’s pleasure dissipates as the crowd begins to doubt that the latest rescue plan will actually rescue anything. Lots of static...no clear signals. The only clear signals that seem to be making their way through the static are the one’s we’d rather not hear — kind of like the Mariachi music that sometimes pierces the static along Route 66. For starters, Emerging Market stocks have been sliding for months — a phenomenon that often portends slowing economic growth worldwide. Additionally, most of the recent economic reports from around the globe suggest the Emerging Markets may be on to something. In other words, they aren’t falling for nuthin’. “Manufacturing activity is contracting across Europe and most of Asia,” Reuters reports. “China’s official purchasing managers’ index (PMI) showed factory activity shrank in November for the first time in nearly three years, while a similar PMI showed Indian factory growth slowed close to stall speed.” Meanwhile, Reuters continues, “The final euro zone manufacturing PMI was confirmed at 46.4, its weakest level in two years, with factory activity in both of its biggest economies, Germany and France, weakening. The UK factory PMI fell to 47.6 in November, its lowest since June 2009, further evidence that Britain’s economy is in dangerous territory.” So far, the US economy — like its stock market — has continued plodding along. Nothing great, but nothing horrible either. That’s good news, relatively speaking. But resilient is not the same thing as bullet-proof. And as Dan Amoss, editor of the Strategic Short Report, recently observed, the resilient US economy may be succumbing to the sluggish conditions that surround it. “The Economic Cycle Research Institute (ECRI), one of the few reliable economic forecasting firms, still shows that the US economy is slowing from its prior growth rate,” Dan observes. “The nearby chart shows the ECRI Weekly Leading Index (in blue, left scale) and the growth rate of this index (in red, right scale).” “Since the end of October, the WLI growth rate has stopped dropping quite so rapidly, from -10% to a recent -7%. One might describe the US economy as resilient, yet this resilience in US economic data isn’t consistent with what we see from the rest of the global economy. Something doesn’t add up.” In other words, caution remains the watchword. A prospective “Santa Claus Rally” notwithstanding, US stocks remain acutely vulnerable to a European Union that is struggling to hold itself together and a global economy that is struggling to grow. But as Chris Mayer, editor of Capital & Crisis, explains below, disciplined investors can prosper — sometimes handsomely — even in the midst of horrible economic circumstances. Don’t miss what Chris has to say below...   Get Rich as Europe Collapses? It sounds weird, but did you know a Euro-collapse could be a GOOD thing for your retirement? It’s true! A little known strategy that could have literally saved your retirement in the middle of the 2008 market meltdown is set to soar again according to one market analyst. But you must act before January 2012, or you risk missing out on this opportunity... Click here to learn more. The Daily Reckoning Presents The Power of “Q”   Chris Mayer Say what you will about John Maynard Keynes (1883-1946). However loathed (or loved) as an economist, he was, undeniably, a great investor. Keynes (pronounced “canes”) piloted the endowment fund of King’s College through the dark years of the Great Depression. He steered the fund to 10-fold gains, excluding income (which the college spent). Keynes also divulged a key insight that helped him do it, back in 1936. “There is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased,” Keynes wrote. On the other hand, there is an incentive to spend money on projects, even “an extravagant sum, if it can be floated off on the stock exchange at an immediate profit.” In that paragraph is an idea so powerful it helped Keynes beat the Great Depression. An American economist named James Tobin polished up Keynes’ insight and popularized?it. In 1969, he created Tobin’s Q, which summed up Keynes’ idea in equation form: Market value of company / replacement value = Tobin’s Q Replacement value is the cost to build an asset from scratch. You may recognize this now. As Keynes surmised, if you can buy, say, a steel mill for $500 per tonne of capacity in the stock market when it costs $1,000 per tonne to build one from scratch, you buy the stock. Most businesses will trade for a premium to replacement value because of the time and risk of building from scratch. But to be most conservative, we want Tobin’s Q to be under 1. This works because the market adjusts over time as market participants buy the cheaper asset. This is also where you tend to see buyouts, which is exactly what happened with PotashCorp. When I recommended this stock to the subscribers of Capital & Crisis, it was selling for about half of its replacement value (a Tobin’s Q of 0.50). BHP made a play for it, the gap closed and the subscribers who acted on my recommendation nearly tripled their money in less than two years. We own many stocks with Qs under 1 (CVA, KRO and OI, to name just a few buy-rated tickers). And many big gains on the back page are in stocks we picked up at low Q ratios (including TIE, MEOH and GSM, to name three). We also want to avoid the extremes on the other end of the spectrum. This takes us to the second part of Keynes’ observation. Let’s look at how this works with a real-world example from the telecom industry of the 1990s. At the height of the boom, telecom companies commanded a stock market value of, on average, $6 for every $1 spent building networks. So, no surprise, the telecom industry spent money like drunken sailors. Level 3 spent $10 billion building out a fiber-optic network. It had no revenues, yet enjoyed a stock market value of over $30 billion. KPN West spent about $2 billion, and the market valued it at $11 billion. Global Crossing traded for eight times what it spent on its network. With that kind of incentive, the industry poured some $500 billion toward creating 150 new carriers — 40 of which were public — and eight new national networks?(with more than 100 miles of optical fiber) from scratch. As author Edward Chancellor summed up: “When a hole in the ground costs $1 to dig but is priced in the stock market at $10, the temptation to reach for a shovel becomes irresistible.” Of course, the whole thing ended badly. The tech bubble finally burst in 2000. Bankruptcies and massive losses soon followed. And this is just one example from many. I’ve yet to find a stock market bubble from any country — from any era — that doesn’t show the same stripes. Despite Q’s powers, I don’t find many investors using it. Maybe it’s because Q takes some digging to figure out. That’s part of its appeal. One group that does use it is Marathon Asset Management. The folks behind Marathon put together a book with Ed Chancellor in 2004. It’s called Capital Account: A Money Manager’s Reports From a Turbulent Decade, 1993-2002. If you want a more-detailed look at how this all works, I’d recommend the book to you. The money managers at Marathon are the only ones I know of who put Tobin’s Q — which they call a “truly remarkable investment tool” — at the heart of their investing process. “The stock market is really a market in replacement capital,” they write. It gives off signals where investment dollars get the biggest bang for the buck, for good or for ill, as we’ve seen. Marathon has used these signals to great effect. In May 2000, Marathon warned the “capital flows unleashed by the new economy” — all that money flowing into tech, telecom and media — would lead to big losses for investors. High Tobin’s Q ratios kept Marathon away. Instead, they steered clients to stocks in which Tobin’s Q was low. At the time, this meant hard assets — such as commodities. It was a smart move, as hard assets enjoyed a stellar decade. Meanwhile, tech, telecom and media blasted away fortunes. What does Tobin’s Q say to buy today? US housing. As it happens, Tobin used the housing market to explain how Q worked, which is worth recounting, given what we’ve been through with the housing bubble. Tobin talked about how home prices far in excess of the cost to build them would lead to a building boom as builders took advantage of the profits available. Over time, though, the market would adjust. “In the longer run,” Tobin wrote, the building boom would “bring market values in line with replacement costs, lowering the former and, possibly, raising the latter.” This is exactly what happened. Prices came way down. The wide profit premium that came from building houses vanished. Today, in some markets, houses trade below replacement cost — a Tobin’s Q below 1. And that’s why we’re building new houses at a rate of around 500,000 annually, down from a 1.6-2.0 million run rate pre-bubble. If he were alive today, Keynes would be a buyer. Following the indicator inspired by his idea, count me bullish on housing as well. Regards, Chris Mayer, for The Daily Reckoning Joel’s Note: So what else is Chris bullish on? What other gems has our value maven uncovered while foraging around the seldom-searched, historical archives of Great Investor Playbooks? His next Capital & Crisis alert is due out later this week. Grab a subscription before it hits the virtual stands and sneak a look at the issue’s back page, which includes the entire portfolio (tickers and all), research notes and buy/sell price targets. Here’s where to go.   Secret Photos China Doesn’t Want You To See A new groundbreaking project is threatening China’s global rare earth monopoly. This little-known company’s operations are unlike any other in the world. And could be incredibly lucrative for early movers. Check out this epic story by clicking here.   Bill Bonner Changing Views on Growth and Economic Recovery   Bill Bonner What’s new? When we signed off last week, the Germans and the French were trying to hold Europe together. This morning, they are still trying. “Don’t you live in Europe?” asked a friend at a party over the weekend. “Yes...much of the time.” “Well, maybe you can tell me what is going on with this European debt crisis?” “I was hoping you would tell me.” The closer you to get to Europe, the harder it is to see what is going on. In the trees of constitutional changes, pledges of solidarity, plans A-Z, official and unofficial announcements from more than a dozen different sovereign countries and half a dozen European agencies...it’s hard to see the forest of debt. Debt levels need to come down. And falling debt levels mean a slumping economy. The rest is detail. In America, stock market investors generally decided to ignore the debt problem last week. The unemployment rate went down, largely because people who couldn’t find jobs were taken off the list. Consumers still seemed ready to buy, as long as the price was right. And Congress does not seem serious about cutting spending...which gives people hope, either because they’re dim enough to think that Congress knows what it is doing or they’re bright enough to know it doesn’t. Either way, they’re sure the US government will spend, spend, spend...until it can’t spend any more. People tend to view the future through the lens of the past. If you’re under 70, you have lived almost all your life in a world where economic growth was a fact of life. It slowed sometimes. It stopped from time to time. But it always came back. All you had to do was to stick with it. Whether you were an investor, a businessman, or a householder, you learned that as long as you could stay the course, you would probably come out okay. Your investments would go up. Your business would do better. And your standard of living would rise. Naturally, you came to believe that that was the way things were s’posed to be. Economist David Rosenberg explains the US mindset with the following quote: Because human psychology is slow to change, a broad economic move usually occurs in three stages. The first stage begins when some unexpected event shatters an overdone psychological environment. Yet, while some people respond immediately to this new lesson, most people, as they find it outside their past experience, do not believe it. They need more evidence — that is, a second stage. Typically, the majority become convinced during the second stage and therefore the psychological background changes. People begin to act differently, and their behavior soon affects the performance of the economy. (Dick Stoken, as quoted by Arthur Zeikel in On Thinking) But Rosenberg agrees with us. Something big has happened. Something has changed. And it could change the way we think. Instead of believing that ‘recovery’ is right around the corner, we may begin to think it will never come. Rosenberg says that major changes in our attitudes will come in 8 different areas: IGHT AREAS OF BEHAVIOURAL CHANGE TO WATCH FOR IN 2012 1. Frugality on the part of the global consumer (living within our means; retirement with dignity) 2. Austerity on the part of sovereigns (spending cuts/tax reform) 3. Nationalism (an umbrella for protectionism and isolationism: mean reversion for globalization) 4. Political movement along the ideological and fiscal spectrum (from gridlock to change) 5. Geopolitical change (wars, elections and regime changes) 6. Changes in inflationary/deflationary expectations 7. Changes in growth expectations 8. Changes in asset allocation preference (fund-flows/de-risking) He may be right. Markets make opinions. And more thoughts... The Pentagon continues to carry out Osama bin Laden’s plan to hobble America. Remember, he outlined his strategy on video. He said he would sucker the US into very expensive, unwinnable wars. He wouldn’t defeat the US military. Instead, he would allow it to spend itself to self-destruction. The strategy is working: US’s Afghan Headache: $400-a-Gallon Gasoline Military Air Drops Fuel Barrels to Avoid Dangerous Convoys By NATHAN HODGE With more American troops on the ground, and to avoid the perils of ground transportation, the military is more frequently using cargo planes to deliver supplies. But as WSJ’s Nathan Hodge reports, the cost is putting a strain on military budgets. OVER EASTERN AFGHANISTAN — Parachuting a barrel of fuel to a remote Afghan base takes sharp flying skills, steady nerves and flawless timing. It also costs a lot of money — up to $400 a gallon, by military estimates. But the Pentagon is stuck with the expense for the foreseeable future, especially given the recent deterioration in US-Pakistani relations. “We’re going to burn a lot of gas to drop a lot of gas,” said Capt. Zack Albaugh, a California Air National Guard pilot deployed with the 774th Expeditionary Airlift Squadron. He spoke just before a recent mission to supply a remote base near the Afghanistan-Pakistan border, scene of cross-border rocket attacks that have heightened regional tensions this fall. But for now, nearly 100,000 US troops are on the ground in Afghanistan, often stationed in difficult-to-reach outposts that depend on pallets of food, water, ammunition and fuel that are dropped by parachute out of cargo planes. Since 2005, the Air Force has increased by nearly 50 times the amount of supplies it air-drops to remote bases, partly as a way to avoid dangerous land-based fuel convoys. *** Bin Laden was wasting his time. Even without his help, the Pentagon was turning into a zombie army. The Most Top-Heavy Force in US History By BEN FREEMAN In September, I testified before the Senate Armed Services Subcommittee on Personnel about the military becoming increasingly top-heavy as a result of growth in the proportion of general and flag officers at the Pentagon. This trend, which we at POGO dubbed Star Creep, is costly to taxpayers who have to foot the large bill for every new general and admiral. It also hinders military effectiveness by leading to what Gates referred to as a “bureaucracy which has the fine motor skills of a dinosaur.” My fellow witnesses at the hearing — several generals and admirals as well as former Under Secretary of Defense for Personnel and Readiness Clifford Stanley — assured the concerned Committee that they had everything under control. They cited Gates’ Efficiency Initiatives, which purportedly eliminate 102 general and flag officer positions, as evidence of the DoD’s commitment to combating Star Creep. Stanley confirmed to Chairman Jim Webb (D-VA) that Gates’ successor — Secretary of Defense Leon Panetta — supported these efforts and, “has accepted the policies and the things put in place by his predecessor.” (Stanley tendered his notice of resignation in late October.) What Senator Webb and I did not know at the time — and perhaps Stanley did — was that Gates’ initiative to cut general and flag officers had already come to a screeching halt. Data that were released recently on the DoD personnel office’s website tell the tale. Between May and September, more than 10,000 enlisted personnel were cut by the DoD, possibly in preparation for the end of military operations in Iraq, while more than 2,500 officers were added. Consequently, for the first time in the more than 200 years that the US has had a standing military, there are fewer than five enlisted personnel for every officer. In other words, today’s military is the most top-heavy force in US history. The Costs of Star Creep The cost to taxpayers of uniformed military personnel increases markedly with their rank. In just basic compensation, these six new generals will cost taxpayers more than $1.25 million per year. Over the next ten years, they’ll cost taxpayers more than $14 million (methodology). The total cost to taxpayers of Star Creep is not trivial, even in the Pentagon’s bloated budget. Since the war in Afghanistan began, the Pentagon has added 99 general and flag officers, a rate of growth that’s tops among all DoD uniformed personnel groups... In 2012, these general and flag officers will cost taxpayers more than $22 million in just direct financial compensation. Between 2012 and 2021, they’ll cost nearly $250 million. But the cost of Star Creep only begins with direct compensation. Other costs that surround generals and admirals — such as staff, contractors, and travel — increase with higher ranks. For example, Bloomberg recently reported that taxpayers in Huntsville, Alabama, footed a $3.8-million bill to build luxurious homes for generals in a successful effort to keep Pentagon pork flowing into the area. One such home, built for a major general, was a sprawling 4,200-square- foot mansion that included granite countertops, hardwood floors, and stainless steel appliances. Luxurious homes are just the beginning of the extravagances available to top military commanders. According to Raymond Dubois, former DoD director of administration and management from 2002 to 2005, there are other perks: A four-star has an airplane. A three-star often doesn’t... Can a three-star get an airplane when he needs it? Not always. Does a four-star get an airplane when he needs it? Always. Many times he’ll already have a G5 sitting on the runway, gassed up. [These] are the kinds of costs that are fairly significant when you add them all up. In his August 2010 speech on Efficiency Initiatives, Gates referred to these perks as “the overhead and accoutrements that go with” senior positions, be they military or civilian, within DoD. In an interview with Newsweek, Gates bemoaned these accoutrements and entourages that surround generals and admirals, which he believes are indicative of a military leadership that is “suffering from an inflated sense of entitlement and a distorted sense of priorities.” Regards, Bill Bonner, for The Daily Reckoning ------------------------------------------------------- Here at The Daily Reckoning, we value your questions and comments. 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